Externalities
Written By Amina Meirkhan| Proofread by Yasmin Uzykanova
Subject vocabulary:
Spillover effects - effect of one situation on another situation.
External costs - adverse spillover effects of consumption and/or production that negatively affect third parties.
External benefits - positive spillover effects of consumption and/or production that benefit third parties.
Private costs - costs of economic activity to individuals and firms.
Social costs - costs of economic activity to society, the individual, and the firm.
Personal benefits - rewards of economic activity to individuals and firms.
Social benefits - benefits of economic activity to society, the individual, and the firm.
Third parties - people outside the business.
Subsidy - money paid by a government or an organization to lower prices, reduce the cost of production/service provision, and encourage the production of a particular good.
Opportunity cost - the cost of the following best alternative given up.
Multinational corporations (MNCs) - companies operating in many different countries.
Examples of external costs: are noise/air/water pollution, overcrowding, traffic congestion, and resource depletion.
External benefits of consumption:
Education - if people are well educated, they can do highly skilled and socially beneficial jobs. This increases productivity and the standard of living for society. Higher levels of education lower unemployment, improve household mobility and raise rates of political participation - all of which benefit the community.
Health care - if people are healthier, they can work more efficiently, making contributions to economic output and paying taxes, which benefits society.
Vaccinations - if more individuals are vaccinated, non-vaccinated people are less likely to be infected because the number of people who can transmit the disease is reduced overall.
Formula to calculate social costs (for social benefits, use benefits instead of costs):
Private Costs + External Costs ( Negative externalities)
Government policies to deal with negative externalities:
Taxation - if a tax is imposed on a firm causing externalities, production costs will increase, and prices charged by the firm will rise. This decreases demand for the product, therefore reducing the production of externalities. However, demand for addictive products might not fall.
Subsidies - money can be offered to firms as an incentive to reduce their externalities. Subsidies can also be given to firms that produce external benefits. However, opportunity cost is a problem because money spent on subsidies to reduce external costs/produce benefits might be used more efficiently.
Fines - paying fines might discourage firms and individuals from causing external costs because a penalty is a cost to them.
Government regulation - governments can pass legislation and laws to protect the environment and society. However, it is challenging to make firms and individuals obey laws, as governments might lack the commitment or resources for enforcement. In addition, some firms producing externalities are well-resourced multinationals ready to resist legal disagreements.
Pollution permits - this gives firms the right to discharge a certain amount of polluting materials. These permits are tradable, meaning a firm can sell its pollution permit if it has found a way to reduce its pollution. This incentivizes innovating of new technology that reduces pollution because selling permits can generate profit. However, the government has to carefully decide on the number of permits issued because decay is difficult to measure. Firms can disguise their pollution levels, which are also affected by the reduction deals of each country. In addition, the costs of permit administration are high.
